China Gas Utilities:Sector growth story sustainable,upgrading CR Gas to Buy

Upgrading CR Gas, also prefer BEHL and ENN

    Sustainable volume growth, manageable margin risks and improving free cashflows will support the gas sector’s growth story over 2017-19. Looking into2018, valuations are not demanding at an average 12x P/E. Specifically, wenow upgrade CR Gas, a high-quality laggard, to Buy, as we believe the marketunderestimates its coal-to-gas potential, is overly concerned about margin risksand ignores its best-among-peers balance sheet and FCFs. At currentvaluations, we also prefer BEHL (deeply discounted value play) and ENN (keycoal-to-gas beneficiary with cheap valuation).

    Sustainable volume growth story supported by coal-to-gas conversions

    We estimate an additional 69bcm/year volume upside from coal-to-gasconversions by 2020, contributing nearly half of China’s total incremental gasdemand. We now expect a 15% gas volume CAGR in 2017-20E in China,achieving 10% energy mix by 2020. Historically, the volume growth of leadinggas players is usually 5-10ppt higher than the national average and we expectthe trend to continue. Besides ENN (Hebei and coastal focus) and China Gas(North China focus), which have been recognized by the market as key coal-togasbeneficiaries, CR Gas also looks well-positioned with the largest exposure(14projects) to 2+26cities and more big city projects, where governments aremore active and able to afford subsidies.

    Margin risks manageable, winter gas shortage is a double-edged sword

    In this report, we dive deeper into gas sales margin trends by analyzing fourfactors that could affect margins. Overall, we expect margins to trend downgradually but at a tolerable rate (Rmb4-12cents/cm over three years). Potentialwinter non-residential city-gate price hikes (likely 15-20%) is another round ofstress test but we believe the risks are manageable. On the positive side,winter gas shortage has pushed up domestic LNG prices to a two-year high,helping eliminate the threat from LNG direct delivery, the price advantages ofwhich have diminished sharply in recent months.

    Rural opportunities: connection visibility vs. gas sales uncertainties

    We see increasing visibility of new connection growth in rural areas due tostronger pushes from local government; therefore, we believe China Gasshould be able to meet its aggressive connection target. Our typical ruralproject model suggests a 8%/11% project IRR/equity IRR but at the same timewe notice the IRR is very sensitive to many moving parts, including actual gasusage, dollar margin, capex and opex, all of which is debatable due to lack ofmature projects as benchmark. Variance of risk appetite might explain gasdistributors’ differing attitude towards rural opportunities. We respect ChinaGas’s pioneer spirit in rural areas and meanwhile agree with ENN and CR Gasabout their discretion and more disciplined return requirements.

    Valuations and risks

    We use DCF (WACC of 7.6-8.3%) and SOTP to derive target prices. Key risksinclude weaker demand growth, harsher margin squeeze, policy uncertainties.